JAMES A. WOOTEN
A Better Way to Promote
Solvency in Defined-Benefit
Pension Plans
This paper was prepared for a May 11, 2007 meeting of the Tobin Project Retirement Security Working Group.
ver the last three decades private-sector defined-benefit [DB] pension plans
Jim Wooten is a Professor
of Law at Buffalo Law
in the United States have experienced a marked, even precipitous, decline.
School,
State University
Many lawmakers, stakeholders, and scholars have rallied to the defense of DB
of New York and Chair
plans, while more than a few analysts have predicted their demise. Whether private
of the Tobin Project
DB plans survive or disappear, they will create financial risk for the Pension BeneRetirement Security
fit Guaranty Corporation [PBGC] for decades to come. If the PBGC fails, there
Working Group.
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is every reason to believe taxpayers will pick up the tab for obligations the PBGC
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guarantees but cannot CIRCULATE
pay. This potential WITHOUT
liability could amount
to tens or even
hundreds of billions of dollars. Whatever the future holds, the substantial risk of
taxpayer liability underscores the need for Congress to devise effective laws for
promoting the solvency of DB plans. Since the enactment of the Employee Retirement Income Security Act of 1974 [ERISA], the principal tool for promoting DB
solvency has been command-and-control regulation of pension contributions. This
essay explains why ERISA’s solvency regime has failed to achieve its regulatory
purpose and outlines an alternative regulatory strategy that holds greater promise.
O
To understand why private DB plans—in particular, collectively-bargained singleemployer plans—are persistently underfunded, it helps to look at funding practices
before Congress passed ERISA. Before ERISA, employees had a strong incentive
to care about solvency because they suffered the entire loss if their plan could not
meet its obligations. Nonetheless, virtually all collectively-bargained single-employer
plans were significantly underfunded before Congress passed ERISA.1 Far from
being the product of fraud or malfeasance, the underfunding in these plans was a
reasonable response to the broader economic constraints on collective bargaining.
T H E T OB IN
P RO J EC T
One Mifflin Place, Suite 240
Cambridge, MA 02138
1 See James A. Wooten, The Employee Retirement Income Security Act of 1974: A Political History (Berkeley: University of California
Press/Milbank Memorial Fund/Employee Benefit Research Institute, 2004), 67–69, 141; Steven A. Sass, The Promise of Private
Pensions: The First Hundred Years (Cambridge, Mass.: Harvard University Press, 1997), 183–86.
J A M E S A . W OO T E N A Better Way to Promote Solvency in Defined-Benefit Pension Plans
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t (617) 547-2600
f (617) 547-2601
www.tobinproject.org
Employers do not have unlimited funds to spend on compensation.2 For this
reason, employers and employees face trade-offs between current compensation, such
as wages and employee benefits, and deferred compensation. The more resources
an employer devotes to current compensation, the less it has to pay deferred
compensation. Employers and employees also face tradeoffs among the benefit
levels, risks, and cost of a pension plan. For example, employer contributions that
are set aside to secure future pensions could have been used to pay higher benefits
to retirees today. Before ERISA, union representatives generally sought to bargain
relatively liberal pension benefits because larger pensions encouraged older workers
to retire. To rapidly fund liberal pensions, an employer must make large contributions to its pension plan. Unions agreed to slower funding of pensions for future
retirees because this allowed employers to pay higher wages and benefits to current
workers and higher pensions to current retirees. But as the notorious Studebaker case
showed, slower funding created the risk that a plan would default on its obligations.
In passing ERISA, Congress meant to protect employees from default risk. To this
In passing ERISA,
end, Title IV of ERISA establishes an insurance program that shifts most of the
Congress meant to
default risk of an underfunded plan to the PBGC. The insurance program also
protect employees
creates “moral hazard.” Moral hazard refers to the possibility that the availability of
from default risk.
insurance will cause changes in conduct that increase the losses an insurer must pay.
To this end, Title IV
ERISA creates moral hazard in two ways. First, by shifting default risk from plan
of ERISA establishes
participants to the PBGC, ERISA reduces the incentive for employees to demand an insurance program
adequate funding. This creates downward pressure on pension assets, which increases
that shifts most
the shortfall when plans
default. Second, when
a plan defaults,
PBGCCITE
insures OR of the default risk
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participants based on what their plan promised, rather than what their employer
of an underfunded
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reasonably could afford. This gives employees an incentive to push their employer
plan to the PBGC.
to make extravagant promises. The result is upward pressure on pension liabilities,
The insurance
which also increases the shortfall PBGC must insure when it takes over a plan.
ERISA’s drafters perceived the threat that moral hazard posed to the PBGC. They
sought to counter this threat by creating minimum funding standards that force (or
purport to force) employers to fund pension obligations in advance. The funding
regime has done a poor job of promoting solvency, however, because it is virtually
impossible to draft contribution mandates that are both feasible for plan sponsors
and enforceable for regulators.3
program also creates
“moral hazard.”
ERISA’s minimum funding standards create affirmative obligations: they force
employers to make pension contributions. Because ERISA obliges employers to act,
lawmakers rightly worry about whether it will be feasible for employers to do what
the standards demand. This concern with feasibility manifests itself in a variety of
provisions that smooth an employer’s contribution obligations or grant flexibility in
2 See generally Wooten, ERISA: A Political History, 52–61.
3 On tradeoffs between feasibility and enforceability, see generally Colin S. Diver, “The Optimal Precision of Administrative Rules,”
93 Yale L. J. 65, 70-71 (1983); Stephen Breyer, Regulation and Its Reform (Cambridge, Mass.: Harvard University Press, 1982),
263–65, 267–69.
J A M E S A . W OO T E N A Better Way to Promote Solvency in Defined-Benefit Pension Plans
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the timing or amount of contributions. Moral hazard highlights the problem
of enforceability. The federal guaranty of pension obligations creates a conflict
between the goals of ERISA’s solvency regime and the interests of the entities
ERISA regulates. When the targets of regulation have interests that conflict with
regulatory goals, regulation is unlikely to be effective unless it is so constraining
that the targets cannot act in a manner that undermines the regulatory purposes.
The result is a sharp conflict between the feasibility and enforceability of ERISA’s solvency regime. If the minimum funding standards are to fulfill their regulatory purpose, they must prevent employers and employees from acting on the incentives the
insurance program creates. This requires regulations that dictate contributions on the
basis of mechanical calculations that give sponsors little capacity to plan and little discretion in the timing or amount of contributions. Unfortunately, the sort of mechanical rules that will make the funding standards more enforceable will be less feasible
for sponsors because contribution obligations will become more volatile (unless a plan
immunizes its obligations) or because contribution obligations will increase (if a plan
immunizes its obligations). In sum, reforms that make ERISA’s funding standards
more enforceable will produce greater contribution volatility or higher contribution
obligations, which will make it less feasible for employers to sponsor DB plans,
while reforms that make contribution obligations less volatile and give plan sponsors
more flexibility will compromise enforceability by giving employers and unions more
opportunities to engage in practices that undermine plan solvency and the PBGC.
A better approach to promoting solvency would give a larger role to regulations
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that address the liability side of the pension balance-sheet. In particular, Congress
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should place greater reliance
on rules that restrict
benefit increases
by underfunded
plans. Unlike ERISA’s minimum funding standards, rules that restrict benefit
increases do not create affirmative obligations. Benefit restrictions do not oblige
an employer to do anything; they tell the sponsor what it may not do—increase
benefits when a plan is poorly funded. Because benefit restrictions do not force
sponsors to perform affirmative acts, there is no need for concern that the rules
will create infeasible obligations. In other words, statutory restrictions on benefit
increases do not create a conflict between feasibility and enforceability.
Because benefit restrictions do not raise feasibility concerns, they can be applied
using simple, relatively transparent calculations. For example, asset and liability
values under a benefit restriction can be calculated on a marked-to-market basis.
In addition, the absence of feasibility concerns allows a benefit restriction to take
account of considerations that cannot be used to calculate contribution obligations.
For example, although employers with poor credit ratings pose a significant risk
to the PBGC, a regulation that ramped up their contribution obligations might harm
the PBGC by pushing weak firms into bankruptcy.4 Using credit ratings in the
A better approach to
promoting solvency
would be to give
a larger role to
regulations that
address the liability
side of the pension
balance-sheet. In
particular, Congress
should place greater
reliance on rules
that restrict benefit
increases by underfunded plans.
4 See the criticisms of the Bush Administration’s proposal to link contribution obligations to credit ratings in House Ways and Means
Committee, President’s Proposal for Single-Employer Pension Funding Reform: Hearing before the Committee on Ways and Means,
109th Cong., 1st sess. (2005), 50, 76, 100–101.
J A M E S A . W OO T E N A Better Way to Promote Solvency in Defined-Benefit Pension Plans
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application of benefit restrictions creates no such problem. Indeed, a rule that prevented weak firms from increasing pension benefits when they had not funded their
existing obligations would make it harder for such firms to overextend themselves.
Enactment of more stringent benefit restrictions also would improve incentives for
funding. Under current law, employees have little reason to care about pension funding because the PBGC pays benefits if their plan does not. If ERISA prevented
employers from increasing benefit levels unless a plan had attained a high level of
solvency, employees would have a direct incentive to care about funding. Giving
employees a reason to care about funding is bound to have a salutary effect on the
solvency level of pension plans.
Another advantage of greater reliance on benefit limitations is that it will address
solvency issues before “the horse is out of the barn.” Even after passage of the
Pension Protection Act of 2006, ERISA allows a sponsor to increase benefit levels
when it has not demonstrated that it can afford the promises it has already made.
Experience has shown that if sponsors can overextend themselves, some will do so.
By the time funding problems emerge, however, “the horse is out of the barn”
in the sense that the sponsor has “overpromised” to such an extent that it is or can
plausibly claim to be unable to meet its statutory contribution obligations. Because
the PBGC faces potential liability for these benefit promises, Congress looks for
ways to help overextended firms fund their way out of their difficulties. This commonly involves granting special treatment to overburdened employers or industries,
which undermines the credibility of the funding regime. Clear, strict benefit resDISCUSSION PAPER: DO NOT CITE OR
trictions could stop firms from overpromising in the first place.
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Finally, the current funding regime mandates conduct that lawmakers hope will
promote solvency. To draft effective standards, lawmakers must figure out what
actions by employers will produce the result that Congress desires. Yet pension
funding is extraordinarily complex. Actuaries, accountants, and financial economists
disagree about the nature and value of pension obligations and how best to finance
those obligations.5 When experts disagree, it seems very unlikely that legislators will
be able to divine the particular course of conduct that best promotes solvency.
Greater reliance on benefit limitations would not require lawmakers to resolve issues
on which experts disagree. Rather than prescribing actions that employers must
undertake, benefit restrictions set a target or outcome that a plan must achieve before
the employer may increase benefits. If the plan meets the target, the employer may
do so. If the plan does not meet the target, the employer may not. Reliance on
benefit restrictions allows lawmakers to define a target and leaves it to the experts
to determine how best to reach that target.
5 See the papers presented at the symposium on the Great Controversy: Current Pension Actuarial Practice in Light of Financial
Economics, available at http://66.216.104.119/library-html/m-rs04-1-tableofcontents.html.
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